Wall Street's love-hate for Treasury plan

ROAD TO RESCUE

• Home prices up for 1st time in 3 years
• New home sales: 'Really good news'
• Wall Street: Here comes the hard part
• 7 regional banks fail
• Banker: "TARP helped avert a global calamity"

Does the Obama Administration's latest bailout plan encourage the very behavior that got us into this mess?

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NEW YORK (Fortune) -- The Obama Administration's latest bailout plan is as rich with irony as it is with potential.

The plan tries to fix the banking crisis by encouraging the very behavior that got us into this mess in the first place -- using buckets full of leverage to buy mortgages, asset-backed securities and other so-called toxic assets. Moreover, it requires the participation of the very folks -- Wall Street bankers and investors -- whom officials in Washington have spent the last two months threatening and vilifying.

At its core, the Public-Private Investment Program (PPIP) harkens back to what the original bank bailout bill was supposed to do when it was first passed by Congress last fall: remove toxic assets from bank balance sheets, thereby freeing up more money for lending. The mechanics of the program would operate somewhat differently for stand-alone loans than for debt securities (basically bundles of loans packaged as asset-backed or mortgage-backed securities), but the general approach is the same. The government will match, dollar for dollar, any private-sector funds put towards buying these toxic assets.

And if that weren't incentive enough, the government will also facilitate cheap loans -- think of them as FDIC-guaranteed margin loans -- to private investors who will be able to leverage their distressed-debt purchases six to one.

Here's how it might work: Say a bank has a pool of residential mortgages with a $100,000 face value that are deemed good risks by the FDIC. The pool is then auctioned off, and in this example, the winning bid is $84,000. Of that, the government puts up $6,000, the private investor another $6,000, and the remaining $72,000 is financed via a FDIC-guaranteed margin loan.

The goal is to jump start the market for toxic debt and put the prices of these loans more in line with the underlying interest payments (which in some cases have declined far less than the market valuation of the loans or debt securities). Theoretically, once the PPIPs start buying and selling this stuff, the valuations will become clearer, opening the door to other private investors who may see opportunity but have shied away up until now due to the lack of price transparency.

That's the upside. The potential downside is what happens if prices continue to fall. And if you think taxpayers are mad now, just wait till they find out that, on account of government-sponsored leverage, a further 15% decline in the debt markets caused them to lose 100% of their investment in PPIPs. Says Tom Atteberry, co-manager of the FPA New Income bond fund: "I do see some irony in the fact that the proposed government solution to the problem looks a lot like a hedge fund and a primary broker -- with the primary broker being the federal government."

There's also a question of whether Wall Street money managers will play ball with a government that has been bad-mouthing them and threatening them with confiscatory taxes. "If they go ahead with the 90% tax, nobody is going to want to work with the government," says a top mortgage-fund manager, referring to the bill passed by the U.S. House of Representatives that would slap a 90% tax on bonuses paid to employees of bailed-out financial companies. "It's a deal killer," says Rick Hughes, co-president of Portfolio Management Consultants, which directs $70 billion in institutional and retail accounts.

Even if the bonus tax isn't implemented, the mortgage-fund manager worries what might happen if PPIP works too well. He envisions a scenario in which money managers are hauled before Congress and accused of making millions on the backs of taxpayers. "I'd rather be attacked by a pack of wild dogs," he says.

There are other, more conventional ways that government involvement could discourage money managers from participating.

FPA's Atteberry notes that under the Treasury Department proposal, the FDIC would provide oversight to the PPIP funds. Atteberry says that if he were putting his firm's capital at risk, he'd want to know more about what "oversight" entails. For instance, will political considerations prevent investors from foreclosing on certain homeowners or force them to offer generous loan modifications? Says Atteberry, "Those are details you need to flesh out if you want to get private investors to come on board."

Of course, it could be that some on Wall Street -- hedge fund managers in particular -- are so desperate for any source of income, they'll gladly accept these risks.

Prime brokers are extending less credit to hedge funds and investors are pulling out their money. So if the government now wants to become hedge funds' new BFF -- their new prime broker as well as their biggest investor -- why quibble about the details? "The reality is that a lot of hedge funds really don't have a business model any more," says veteran Wall Street strategist Ed Yardeni. "The government is basically putting Wall Street back in business with a whole new business model, which is to take all the toxic assets, repackage them and re-sell them at a discount."

"Wall Street is getting paid to re-arrange the deck chairs on the Titanic -- but hopefully with a better outcome."